Judge Jed Rakoff significantly reduced the amount of money the Madoff trustee can potentially recover from "net winners." In Picard v. Katz (S.D.N.Y. 09/27/11), the trustee sought to recover over a billion dollars from defendants Saul Katz and Fred Wilpon on a variety of theories under federal bankruptcy law and New York Debtor and Creditor Law. The court, however, dismissed all claims except those alleging actual fraud and equitable subordination and narrows the standard for recovery under the remaining claims.

First, because Madoff Securities was a registered broker-dealer, the liabilities of its customers are subject to the "safe harbor" of Bankruptcy Code section 546(e), under which a trustee cannot avoid settlement payments made by a stockbroker in connection with a securities contract except in cases of actual fraud. The court relied on the plain language of the statute and rejected the trustee's argument that the policy behind the provision did not warrant its application to payments by Madoff Securities to its customers. Accordingly, the court rejected all the trustee's claims based on principles of preference or constructive fraud.

Second, with respect to claims based on actual fraud, the court applied the bankruptcy code's avoidance provision permitting the trustee to clawback payments made by Madoff Securities to its customers within two years of the bankruptcy filing. The bankruptcy code, however, provides that a transferee "that takes for value and in good faith" may retain its interest to the extent it gave value to the debtor in exchange for such transfer. Accordingly, the trustee cannot recover the principal invested by a Madoff customer absent bad faith. The trustee can recover a net winner's profits regardless of good faith.

Third, the court rejected the customers' argument that, so long as they acted in good faith, their profits, as reflected on their monthly statements, were legally binding obligations of Madoff Securities, so that payments of those profits were simply discharges of antecedent debts. Rather, as to payments received in excess of their principal, customers would have to show that they took for value.

Fourth, the court leaves open whether the trustee can avoid as profits only what defendants received in excess of their investment during the two-year look back period or instead the excess they received over the course of their investment with Madoff. According to the trustee's complaint, defendants' profits amounted to about $83 million in the two-year period and about $295 million over the course of their investment.

Fifth, the court discusses what lack of "good faith" means in this context. Both sides agreed that actual knowledge (which the trustee did not allege) or willful blindness (which the trustee did allege and about which the court expresses skepticism) would constitute lack of good faith. The trustee also argued that "inquiry notice" and failure to investigate constituted lack of good faith; the defendants, of course, disagreed. The court rejected the latter in the context of a SIPA trusteeship, where bankruptcy law is informed by federal securities law. Just as fraud, in the context of federal securities laws, requires scienter, so too "good faith" in a SIPA bankruptcy implies a lack of fraudulent intent. In particular, an investor generally has no duty to investigate its broker in the absence of red flags that suggest a high probability of fraud.

Finally, the trustee can subordinate the defendants' own claims against the estate only by proving that the defendants invested with Madoff Securities with knowledge, or in reckless disregard, of its fraud.